The following discussion should be read in conjunction with the Consolidated Condensed Financial Statements and the related notes that appear elsewhere in this document.
The information in this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended ("Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended ("Exchange Act"), which are subject to the "safe harbor" created by those sections. Forward-looking statements are based on our management's beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as "may," "will," "should," "could," "would," "estimate," "project," "predict," "potential," "continue," "strategy," "believe," "anticipate," "plan," "expect," "intend" and similar expression intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this Quarterly Report on Form 10-Q in greater detail under the heading "Risk Factors." Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this filing. You should read this Quarterly Report on Form 10-Q completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.
Octoen®, Octoen Plus ®, Octoen II®, Nitrox® and Pure VuTM are trademarks and registered trademarks of Cavium Networks, Inc. Overview
We are a provider of highly integrated semiconductor products that enable intelligent processing for networking, communications, storage, wireless, video and security applications. We market and sell our products to providers of networking equipment that sell their products into the enterprise network, data center, broadband and consumer, and access and service provider markets. Our products are used in a broad array of networking equipment, including routers, switches, content-aware switches, unified threat management, or UTM and other security appliances, application-aware gateways, voice/video/data, or triple-play, gateways, wireless local area network, or WLAN and third-generation, or 3G access and aggregation devices, storage networking equipment, servers and intelligent network interface cards. We focus our resources on the design, sales and marketing of our products, and outsource the manufacturing of our products.
From our incorporation in 2000 through 2003, we were primarily engaged in the design and development of our first processor family, NITROX, which we began shipping commercially in 2003. In 2004, we introduced and commenced commercial shipments of NITROX Soho. In 2006, we commenced our first commercial shipments of our OCTEON family of multi-core MIPS64®processors. We introduced a number of new products within all three of these product families in 2006. In 2007, we introduced our new line of OCTEON based storage services processors designed to address the specific needs in the storage market, as well as other new products in the OCTEON and NITROX families. In 2008, we expanded our OCTEON and NITROX product families with new products including wireless services processors to address the needs for wireless infrastructure equipment. In 2009, we announced the next generation OCTEON II Internet Application Processor ("IAP") family multi-core MIPS64® processors, with one to 32 cores to address next generation networking applications support converged voice, video, data mobile traffic and services. We expect to begin shipments of OCTEON II processors towards the end of 2009. In the third quarter of 2009, we expanded our NITROX product family offering to include the NITROX DPI processor, which facilitates several significant enhancements and increased performance.
We acquired W&W Communications, Inc. ("W&W") in the fourth quarter of 2008. This acquisition launched us into the high growth video processor market with a broad product line called PureVutm. The PureVutm family of video processors and modules incorporate proprietary and patent pending video technology that produces perceptual lossless video quality and delivers practically zero latency with extremely low power and cost. Through the acquisition of substantially all of the assets of Star Semiconductor Corporation ("Star") in the third quarter of 2008, we also added the Star ARM-based processors to our portfolio to address connected home and office applications. For a complete discussion on our 2008 acquisitions, see "Note 5 Business Combinations" in Item 1, of this Quarterly Report, which is incorporated herein by reference.
Since inception, we have invested heavily in new product development and we achieved our first quarter of profitability during the quarter ended September 30, 2007. Our net revenue has grown from $19.4 million in 2005 to $34.2 million in 2006, $54.2 million

in 2007, $86.6 million in 2008 and $69.1 million in the nine months ended September 30, 2009, driven primarily by demand in the enterprise network and data center markets, and more recently in 2008 and 2009 by increased demand in the broadband and consumer markets. We expect sales of our products for use in the enterprise network and data center markets to continue to represent a substantial portion of our revenue in the foreseeable future.
We primarily sell our products to OEMs, either directly or through their contract manufacturers. Contract manufacturers purchase our products only when an OEM incorporates our product into the OEM's product, not as commercial off-the-shelf products. Our customers' products are complex and require significant time to define, design and ramp to volume production. Accordingly, our sales cycle is long. This cycle begins with our technical marketing, sales and field application engineers engaging with our customers' system designers and management, which is typically a multi-month process. If we are successful, a customer will decide to incorporate our product in its product, which we refer to as a design win. Because the sales cycles for our products are long, we incur expenses to develop and sell our products, regardless of whether we achieve the design win and well in advance of generating revenue, if any, from those expenditures. We do not have long-term purchase commitments from any of our customers, as sales of our products are generally made under individual purchase orders. However, once one of our products is incorporated into a customer's design, it is likely to remain designed in for the life cycle of the product. We believe this to be the case because a redesign would generally be time consuming and expensive. We have experienced revenue growth due to an increase in the number of our products, an expansion of our customer base, an increase in the number of average design wins within any one customer and an increase in the average revenue per design win.
Key Business Metrics
Design Wins. We closely monitor design wins by customer and end market on a periodic basis. We consider design wins to be a key ingredient in our future success, although the revenue generated by each design can vary significantly. Our long-term sales expectations are based on internal forecasts from specific customer design wins based upon the expected time to market for end customer products deploying our products and associated revenue potential.
Pricing and Margins. Pricing and margins depend on the features of the products we provide to our customers. In general, products with more complex configurations and higher performance tend to be priced higher and have higher gross margins. These configurations tend to be used in high performance applications that are focused on the enterprise network, data center, and access and service provider markets. We tend to experience price decreases over the life cycle of our products, which can vary by market and application. In general, we experience less pricing volatility with customers that sell to the enterprise and data center markets.
Sales Volume. A typical design win can generate a wide range of sales volumes for our products, depending on the end market demand for our customers' products. This can depend on several factors, including the reputation, market penetration, the size of the end market that the product addresses, and the marketing and sales effectiveness of our customer. In general, our customers with greater market penetration and better branding tend to develop products that generate larger volumes over the product life cycle. In addition, some markets generate large volumes if the end market product is adopted by the mass market.
Customer Product Life Cycle. We typically commence commercial shipments from nine months to three years following the design win. Once our product is in production, revenue from a particular customer may continue for several years. We estimate our customers' product life cycles based on the customer, type of product and end market. In general, products that go into the enterprise network and data center take longer to reach volume production but tend to have longer lives. Products for other markets, such as broadband and consumer, tend to ramp relatively quickly, but generally have shorter life cycles. We estimate these life cycles based on our management's experience with providers of networking equipment and the semiconductor market as a whole. Results of Operations
Three and Nine months ended September 30, 2009 and 2008 Net Revenue. Our net revenue consists primarily of sales of our semiconductor products to providers of networking equipment and their contract manufacturers and distributors. Initial sales of our products for a new design are usually made directly to providers of networking equipment as they design and develop their product. Once their design enters production, they often outsource their manufacturing to contract manufacturers that purchase our products directly from us or from our distributors. We price our products based on market and competitive conditions and periodically reduce the price of our products, as market and competitive conditions change, and as manufacturing costs are reduced. We do not experience different margins on direct sales to providers of networking equipment and indirect sales through contract manufacturers because in all cases we negotiate product pricing directly with the providers of networking equipment. To date, all of our revenue is denominated in U.S. dollars.
We also derive revenue in the form of license and maintenance fees through licensing our software products which help our customers build products around our systems-on-a-chip, or SoCs in a more time and cost efficient manner. Revenue from such

arrangements totaled $133,000 and $1.2 million for the three months ended September 30, 2009 and 2008, respectively, and $1.9 million and $1.7 million for the nine months ended September 30, 2009 and 2008, respectively.
Our customers representing greater than 10% of net revenue for each of the periods were:

                                        For the three months         For the nine months
                                        ended September 30,          ended September 30,
                                         2009            2008         2009            2008
   Percentage of total net revenue
   Cisco                                    26 %           24 %          22 %           29 %
   Actiontec                                11 %            *            13 %            *

* Represents less than 10% of the consolidated net revenue for the respective period end. Our distributors other than Avnet are used primarily to support international sale logistics in Asia, including importation and credit management. Total net revenue through distributors was $10.6 million and $9.5 million for the three months ended September 30, 2009 and 2008, or 40.9% and 38.9% of net revenue, respectively, and $25.8 million and $22.8 million for the nine months ended September 30, 2009 and 2008, or 37.3% and 35.4% of net revenue, respectively. While we have purchase agreements with our distributors, the distributors do not have long-term contracts with any of the equipment providers. Our distributor agreements, except as noted below for Avnet, limit the distributor's ability to return product up to a portion of purchases in the preceding quarter. Given our experience, along with our distributors' limited contractual return rights, we believe we can reasonably estimate expected returns from our distributors. Accordingly, we recognize sales through distributors at the time of shipment, reduced by our estimate of expected returns. Revenue and costs relating to sales to distributors are deferred if we grant more than limited rights of returns and price credits or if we cannot reasonably estimate the level of returns and credits issuable. Our distribution agreement with Avnet, Inc. is to distribute our products primarily in the United States. Given the terms of the distribution agreement, for sales to Avnet, revenue and costs are being deferred until products are sold by Avnet to their end customers. For the three months ended September 30, 2009 and 2008, 4.5% and 3.7%, respectively, and for the nine months ended September 30, 2009 and 2008, 5.3% and 3.6%, respectively, of our net revenues were from products sold by Avnet. Revenue recognition depends on notification from Avnet that product has been sold to Avnet's end customers. The following table is based on the geographic location of the original equipment manufacturers or the distributors who purchased our products. The geographic locations of our distributors may be different from the geographic locations of the ultimate end customers. Revenues by geography for the periods indicated were:

                                 Three months ended          Nine months ended
                                    September 30,              September 30,
                                  2009          2008         2009          2008
                                                 (in thousands)
             United States     $    9,002     $ 12,252     $  27,198     $ 32,803
             Hong Kong              5,115        1,095        13,960        1,966
             Taiwan                 4,407        3,786         9,526        9,419
             Japan                  3,241        3,675         8,262        8,515
             Other countries        4,129        3,717        10,134       11,726

             Total             $   25,894     $ 24,525     $  69,080     $ 64,429

Three Months and Nine Months ended September 30, 2009 Compared to the Three Months and Nine Months ended September 30, 2008: Net Revenue. Our net revenue was $25.9 million in the three months ended September 30, 2009, as compared to $24.5 million in the three months ended September 30, 2008, an increase of $1.4 million, or 5.6%. Our net revenue was $69.1 million in the nine months ended September 30, 2009, as compared to $64.4 million in the nine months ended September 30, 2008, an increase of $4.7 million, or 7.2%. The increase in net revenue in the three months and nine months ended September 30, 2009 was mainly attributable

to the increase in sales of $3.8 million and $13.2 million, respectively, in broadband and consumer markets due to increase in demand for our products from our existing and new customers combined with revenue generated from acquisitions completed in 2008. The net revenue growth in the three months and nine months ended September 30, 2009 was partially offset by sales declines of $1.0 million and $8.3 million, respectively, in the data center and access and service provider and enterprise network markets, as a result of the 2009 global economic downturn. Our net revenue from distributors in the three months and nine months ended September 30, 2009 increased by 2.0 and 1.9 percentage points, respectively, due to increased sales by most of our major distributors. Cost of Revenue and Gross Margin. We outsource wafer fabrication, assembly and test functions of our products. A significant portion of our cost of revenue consists of payments for the purchase of wafers and for assembly and test services, amortization of acquired intangibles and amortization related to capitalized mask costs. To a lesser extent, cost of revenue includes expenses relating to our internal operations that manage our contractors, stock-based compensation, the cost of shipping and logistics, royalties, inventory provisions for estimated excess and obsolete inventories, warranty costs and changes in product cost due to changes in sort, assembly and test yields. In general, our cost of revenue associated with a particular product declines over time as a result of yield improvements, primarily associated with design and test enhancements.
We use third-party foundries and assembly and test contractors, which are primarily located in Asia, to manufacture, assemble and test our semiconductor products. We purchase processed wafers on a per wafer basis from our fabrication suppliers, which are currently TSMC, UMC and Fujitsu. We also outsource the sort, assembly, final testing and other processing of our product to third-party contractors, primarily ASE and ISE. We negotiate wafer fabrication on a purchase order basis and do not have long-term agreements with any of our third-party contractors. A significant disruption in the operations of one or more of these contractors would impact the production of our products which could have a material adverse effect on our business, financial condition and results of operations.
Our net revenue, cost of revenue, gross profit and gross margin for the three months and nine months ended September 30, 2009 and 2008 were:

                                For the three months ended                                                   For the nine months ended
                                       September 30,                                                               September 30,
                               2009                   2008              change         % change            2009                   2008              change         % change
                                                 (in thousands)                                                              (in thousands)
Net revenue                $      25,894        $         24,525       $  1,369              5.6 %     $      69,080        $         64,429       $  4,651              7.2 %
Cost of revenue                   12,567                  10,099          2,468             24.4 %            35,520                  24,494         11,026             45.0 %

Gross Profit               $      13,327        $         14,426       $ (1,099 )           -7.6 %     $      33,560        $         39,935       $ (6,375 )          -16.0 %

Gross Margin                        51.5 %                  58.8 %         -7.3 %          -12.3 %              48.6 %                  62.0 %        -13.4 %          -21.6 %

Our gross margin has been and will continue to be affected by a variety of factors, including average sales prices of our products, the product mix, amortization of acquired intangibles, the cost of fabrication masks that are capitalized and amortized, the timing of cost reductions for fabricated wafers and assembly and test service costs, inventory valuation charges and the timing and changes in sort, assembly and test yields. Overall product margin is impacted by the mix between higher performance, higher margin products and lower performance, lower margin products. In addition, we typically experience lower yields and higher associated costs on new products, which improve as production volumes increase.
Three Months and Nine Months ended September 30, 2009 Compared to the Three Months and Nine Months ended September 30, 2008: Cost of Revenue and Gross Margin. Gross margin declined from 58.8% in the three months ended September 30, 2008 to 51.5% in the three months ended September 30, 2009, a decline of 7.3 percentage points. Gross margin declined from 62.0% in the nine months ended September 30, 2008 to 48.6% in the nine months ended September 30, 2009, a decline of 13.4 percentage points. The decline in gross margin in the three months and nine months ended September 30, 2009 compared to the three months and nine months ended September 30, 2008 was primarily due to a shift in product sales mix towards increased sales of lower performance, lower margin products particularly in the broadband and consumer markets. In addition, in the nine months ended September 30, 2009 higher amortization costs of acquired intangible assets and amortization of fair value adjustments of acquired inventory of approximately $2.3 million resulting from the acquisitions completed in 2008 contributed to the gross margin decline.

Research and Development Expenses
Research and development expenses primarily include personnel costs, engineering design development software and hardware tools, allocated facilities expenses and depreciation of equipment used in research and development, and stock-based compensation.
Total research and development expenses for the three months and nine months ended September 30, 2009 and 2008 were:

                                   For the three months ended                                                          For the nine months ended
                                         September 30,                                                                       September 30,
                                  2009                   2008                change            % change              2009                   2008                 change            % change
                                                    (in thousands)                                                                     (in thousands)
Research and
development expenses         $     10,629           $       6,593           $ 4,036               61.2 %         $    30,894           $      18,874           $ 12,020               63.7 %
Percent of total net
revenue                              41.0 %                  26.9 %            14.1 %             52.2 %                44.7 %                  29.3 %             15.4 %             52.5 %

Three Months and Nine Months ended September 30, 2009 Compared to the Three Months and Nine Months ended September 30, 2008: Research and development expenses increased by $4.0 million and $12.0 million, or 61.2% and 63.7%, to $10.6 million and $30.9 million in the three months and nine months ended September 30, 2009, respectively, from $6.6 million and $18.9 million in the three months and nine months ended September 30, 2008. Of the $4.0 million and $12.0 million increase in the three months and nine months ended September 30, 2009, salaries and benefits accounted for $2.1 million and $6.7 million, respectively, and stock-based compensation expense accounted for $0.7 million and $2.2 million, respectively, in each case due to increased headcount mainly resulting from the acquisitions completed in 2008. Consulting services, amortization of intangible assets and other miscellaneous expenses accounted for $1.1 million and $2.7 million of the increase in the three months and nine months ended September 30, 2009, respectively. In addition, workforce reduction related charges of $0.2 million contributed to the overall increase in the nine months ended September 30, 2009. Research and development headcount increased to 232 at the end of September 2009 from 155 at the end of September 2008.
Sales, General and Administrative Expenses Sales, general and administrative expenses primarily include personnel costs, accounting and legal fees, information systems, sales commissions, trade shows, marketing programs, depreciation, allocated facilities expenses and stock-based compensation. Total sales, general and administrative costs for the three months and nine months ended September 30, 2009 and 2008 were:

                                  For the three months ended                                                        For the nine months ended
                                         September 30,                                                                    September 30,
                                 2009                   2008               change           % change              2009                   2008                change            % change
                                                   (in thousands)                                                                   (in thousands)
Sales, general and
administrative               $     6,647           $       5,944           $ 703               11.8 %         $    19,310           $      15,953           $ 3,357               21.0 %
Percent of total net
revenue                             25.7 %                  24.2 %           1.5 %              6.2 %                28.0 %                  24.8 %             3.2 %             12.7 %

Three Months and Nine Months ended September 30, 2009 Compared to the Three Months and Nine Months ended September 30, 2008: Sales, general and administrative expenses increased $0.7 million and $3.4 million, or 11.8% and 21.0% to $6.6 million and $19.3 million in the three months and nine months ended September 30, 2009 from $5.9 million and $16.0 million in the three months and nine months ended September 30, 2008. Of the $0.7 million and $3.4 million increase in the three months and nine months ended September 30, 2009, stock-based compensation expense accounted for $0.5 million and $2.0 million, respectively, and salaries, benefits and commissions accounted for $0.1 million and $1.0 million, respectively, in each case due to increased headcount and higher commissions related to increases in sales. Other miscellaneous expenses accounted for $0.1 million and $0.4 million of the increase in the three months and nine months ended September 30, 2009. Sales, general and administrative headcount increased to 83 at the end of September 2009 from 71 at the end of September 2008.
Other Income, Net. Other income, net, primarily includes interest income on cash and cash equivalents and, to a lesser extent, includes the interest expense component associated with the installment payment of capitalized licenses.

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